1. a. The requirement is to identify a risk factor relating to misstatements arising from fraudulent financial reporting. Answer (a) is correct because historically low levels of earnings may have created pressure on management to at least exceed the previous year’s net income. Answers (b) and (d) are incorrect because there is no indication that the company is involved with overly complex transactions (maintaining lien rights on inventory is not complex) and the industry does not face great technological changes in products. Answer (c)is incorrect because selling to both residential and commercial purchasers presents no particular risk.

2. a. The requirement is to identify the correct statement relating to a risk that might adversely affect J & M’s sales. Answer (a) is correct because the simulation emphasizes the fact that high unemployment may affect the company’s sales—for example, if individuals stop purchasing new homes and the demand for lumber decreases. Answer (b) is incorrect because selling to different types of customers diversifies away some of the risk of incurring declining sales. Answer (c)is incorrect because product obsolescence does not currently seem a major problem. Answer (d)is incorrect because while the board of directors may not be particularly independent, it is uncertain that such lack of independence would lead to a decline in sales.

3. b. The requirement is to identify the reply that is consistent with a decrease in the quick ratio— (cash + short term investments + receivables) / current liabilities. Answer (b) is correct because the increase in current debt increases the denominator of the quick ratio and thereby decreases the ratio.

4. a. The requirement is to identify the audit finding consistent with a significant decrease in the debt to equity ratio—total debt/total equity. Answer (b) is correct because the profit increases the total equity and thereby increases the denominator of the debt to equity ratio.

5. c. The requirement is to identify an audit procedure that will help the auditor to determine that inventories have been completely included. Selecting items during the count to determine that they have been included on count sheets will help the auditor determine that all items have been included—that is, establish the completeness of inventories. Following this procedure the auditor may find items not included on the count sheets that should have been included.

6. d. The requirement is to identify an audit procedure that will help the auditor to determine that inventory cost amounts are accurate. Selecting a sample of recorded items and examining supporting vendors’ invoices and contracts will reveal a situation in which costs on those invoices/contracts has not been properly included in the records.

7. We will not provide a detailed memo here. Your memo should be well written, and well organized. Although you should not have provided a list such as we have provided below, your memo might have included points such as the following:

  • The company has established an audit committee for the first time this year.
  • The members of the audit committee (Pat Murphy, Sally Adams, Jody Jengelen).
  • Pat Murphy is thechair of the audit committee.
  • With Murphy as chair, the independence of the audit committee is very much at issue.
  • You might also have indicated that the CPA firm should obtain additional information about Sally Adams and Jody Jengelen.
  • The overall lack of audit committee independence is often the case with small companies such as J & M. Indeed, many small companies have no audit committee.

8.

Independent Auditor’s Report

We have audited the accompanying balance sheets of X Company as of December 31, 20X1 and December 31, 20X1, and the related consolidated statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the Untied States of America.